Fed tightens, China responds

When China experienced an export boom and a large influx of foreign direct investment a decade ago, the People's Bank of China intervened in the foreign exchange market to ease the appreciation of the renminbi. The PBoC exhausted liquidity by raising the reserve ratio of commercial banks. The reserve ratio peaked at 21%, and China's foreign exchange reserves reached $4tn in the process.

In mid-2014, capital started to flow to the US market in anticipation of the Federal Reserve's interest rate increases. As a result, the dollar began to appreciate against all other currencies. The PBoC's response was to reverse its previous measures: the dollar reserve was drawn down to meet the demand in the foreign exchange market and avoid a sharp depreciation of the renminbi. Liquidity withdrawals were sterilised by cutting the reserve ratio to unlocked funds for banks.

By early 2016 China had lost around $800bn of its foreign exchange reserves compared to the mid-2014 peak. A cut of the reserve ratio by the PBoC in March 2016 triggered another round of capital flight. Market sentiment towards the renminbi was already negative, and the cut by the central bank was regarded as signalling broad easing. The Fed's rate increases have triggered a chain of extraordinary PBoC responses.

Cutting the reserve ratio is no longer a useful tool for the PBoC in its sterilisation operations. Instead, a combination of instruments, mainly reverse repurchase agreements, pledged supplementary lending, and medium-term lending facilities (MLF), have been used to inject liquidity into the banking sector. The latter has been the most heavily used tool. In 2016, these facilities contributed a net injection of Rmb2.8tn ($405bn).

Banks must pay interest on MLF funds, which means borrowing costs can be used to reduce leverage. In the first quarter of 2017, MLF rates were increased by 0.2%, indicating policy-makers' intention to reduce leverage and lower financial risk.

MLF gives the PBoC more control over the amount of funds that banks hold and their duration. In practice, however, the one-sided operation forces the central bank to extend the facilities at ever longer maturities. The PBoC stopped offering three-month MLF in August because these facilities matured too soon. Of those facilities extended since October, most have 12-month maturities. Unless the pressure on renminbi depreciation eases and the central bank continues to cut the reserve ratio, the PBoC may need to extend long-term lending facilities at maturities greater than 12 months.

Another problem with MLF is maturity mismatch. Banks cannot use the funds as freely as they would if they could hold lower reserves. As a result, they are unable to prepare long-term plans for funds raised from MLF operations. They may even need to hoard liquidity if they don't know when the PBoC will extend new financing. The problem is exacerbated for small and medium-sized banks, which do not get MLF funds directly from the PBoC and must rely on borrowing from the interbank market at higher costs.

Banks therefore prefer short-term debts and have become active participants in the market of wealth management products, mostly securitised bonds. The market saw a rapid expansion in 2016, facilitated by a significant increase in new issuance of government-related bonds. The upbeat market attracted more issuance of financing bills and corporate bonds, owing to low borrowing costs. In 2016, bond issuance grew by 47%, and wealth management assets of banks increased by more than 30%.

The speculative bond trading took the PBoC by surprise, as these were off-balance-sheet activities outside its realm of surveillance. When several bond defaults occurred in December, policy-makers tightened liquidity, which led to a sell-off in the bond market. In addition, the PBoC announced that it would include wealth management products in its macro prudential assessment of banks. Additional US rate increases in 2017 are sure to incite yet more extraordinary measures in China.

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